Solvency is used as an indicator within the financial statements of an entity. It can be from a company, a legal person or a natural person. It tries to define the economic capacity that one has to face the economic obligations. To find out what capacity you have, you look for a relationship that determines how many assets you have in relation to the liabilities. This relationship happens by dividing the total assets that are owned in relation to the asset.
Not to be confused with the ratio of financial autonomy or having liquidity. Solvency pursues the ability to face the future payments while the financial autonomy ratio pursues the ability of a company or person to borrow. On the other hand, liquidity is not a ratio that has come from somewhere, but popularly, having money is often confused with being solvent. Thus, solvency is a good indicator to analyze a company financially or financially. To understand it more closely, this article will revolve around solvency and explain how to calculate it and how we can interpret this indicator.
How solvency is calculated
The calculation that must be made to determine the solvency level of a company is quite simple. On the one hand, you have to add up all the assets, and then divide that value by the sum of all the liabilities. Let's see it better with an example:
- Assets: Total of 350.000 euros.
- Liabilities: Total of 200.000 euros.
- Assets / Liabilities: 1.75 of solvency level.
As you can see, obtaining this indicator is something simple, however it is important to determine what level of solvency is adequate. Whether it is for your personal finances, if you are the owner of a company, or you are an investor interested in placing your trust and you want to have a reliable and objective variable for analysis.
How to interpret the solvency for an investment
We live in a highly competitive world where no one wants to be left behind. There are companies that manage to produce enough profits so as not to have to borrow or do so minimally. However, the case of most companies pushes to make new investments, often requesting new loans, and it is here where the solvency ratio can indicate to what level you can borrow. As data, this information can always be accompanied by the financial autonomy ratio that we have previously discussed.
What levels are suitable
A company with a ratio lower than the 1.75 that we have given in the previous example, for example having 1.2, would mean that its solvency level is lower. In other words, their ability to acquire new credits, or create new infrastructure, pay more salaries, etc., would be more limited. We can define and it is widely accepted that an adequate level of solvency would be from 1.5. Anything less than 1.5 would be a weaker credit, and the lower it would be.
However, not all industries move in the same way, and there are some where debt levels tend to be lower and others higher (like the world of construction, for example).
How to take into account the history of the solvency level of a company
A solvency ratio accompanied by the ratios of previous years can serve as a guide for investment. It is enough used in fundamental analysis, and a level of solvency determined and sustained over time can be interpreted in various ways.
In the event that the company continues to grow, that is, its Net Worth increases steadily over time and also maintains its solvency level is a good sign. It may be, among other factors, that the management team has defined a good strategy and maintains a balance in its financial statements that are very stable over the years.
If, on the contrary, your solvency is maintained, however, your Net Worth decreases, it is possible that your shares will also decrease. If not, and your shares hold up, investors may either have not noticed the loss in value or there are other strategic plans. This point must be investigated on its own, each company a world (as I usually say).
On the other hand, it goes without saying that a continuous loss of the solvency level in a company is not a good sign, especially if it is sustained, or that a constant increase is a good thing. You have to make sure that the company makes use of these assets, that is, it wants to continue growing. The ideal scenario (or at least one of them) would be to see a company with increasing solvency levels, which may eventually decrease when expanding, and then continue to recover solvency levels, and so on as well.
Insolvency
This swampy ground is where no one would want to get to, also known as bankruptcy or bankruptcy. Insolvency is the opposite of solvency, the inability to meet the payments of money owed. exist two types of insolvency, cash / cash flow and balance sheet.
Insolvency of cash flow or cash is when a company or person does not have liquidity to face future payments, but if you have enough assets. This situation is normally resolved by negotiating with the creditor the payment methods. Usually the debtor has valuable things, such as property, machines, a car, etc., and the creditor can wait to receive payments. This delay is usually penalized in some way, so it may involve a fine or the like, apart from the final payment of the debt.
Balance sheet insolvency occurs when all the assets of a company are even insufficient to face the final payment of the debt. Normally, this situation is considered before the next payment occurs, in which it is already considered that there will be no way to pay the next payments or maintain any type of activity. Before this situation occurs, it is usually decided to maintain the activity (for the benefits it brings). Finally, both creditor and debtor can negotiate this situation and accept a small loss, or negotiate a new debt or form of payment that allows them to maintain the activity.